Getting to the naked truth

A regulatory probe sheds light on manipulative shorting

SHORT-SELLERS perform a valuable function in financial markets, exposing managerial incompetence, corporate fraud or plain overvaluation. Their reward, all too often, is calumny. Witness regulators' rush to ban shorting in 2008 in response to sustained political attacks on the practice.

Like any form of trading, however, shorting is open to abuse. Some firms claim to have been victims of illegal “naked” shorting, where the seller does not arrange to borrow the shares in time to deliver them to the buyer within the standard settlement period. This, they say, has long been a favoured tool of unprincipled traders looking to launch bear raids—usually on small stocks but also, in times of turmoil, on bigger fish like Lehman Brothers. Hedge funds and the prime brokers that serve them have tended to counter that such accusations are smokescreens put up by bosses to mask their own failings.

After years of sitting on their hands, regulators are starting to side with the companies. The Securities and Exchange Commission (SEC) has brought several cases over the past year. The latest alleges that two brothers, Jeffrey and Robert Wolfson, and a firm they traded through made at least $17m naked-shorting numerous shares, including, cheekily, the New York Stock Exchange's parent firm. (A lawyer for one of the Wolfsons says he intends to fight the charges.) The filing shows how the dark art may have been practised.

The SEC rules require traders to locate shares they wish to borrow before selling them short; they must then deliver the borrowed securities to the buyer by a specified date. If delivery has not occurred four days after the trade, it has to be settled, if necessary using securities of like quality.

The Wolfsons' alleged scheme involved a thicket of complex transactions, according to the SEC. One type of trade, a “reverse conversion”, involved taking out options that appeared to offset the short position, making naked shorting look like bona fide marketmaking. Another stock-and-option combination, the “reset”, created the illusion that trades had been settled by having an entity buy the same type and quantity of shares that had been sold short. But the shares were always sold back within days, often in trades between the brothers, which the SEC claims were “sham”. The reset trades meant they could roll over naked-short positions indefinitely.

The SEC says its investigations will continue. Naked shorting is precisely the kind of gaming of the rules by sophisticated insiders that, it fears, could sap the average punter's confidence in stockmarkets. The role of prime brokers in particular is under scrutiny. According to the SEC complaint, unnamed large prime brokers engaged with the brothers in conversion trades that allowed the brokers to build entitlements to hard-to-borrow shares, even if these shares had not actually been located or delivered. The brokers could then lend this apparent inventory of stock to short-selling hedge funds for fees that were several times higher than those from lending freely available shares.

Whether prime brokers knowingly benefited from naked shorting could become clearer as the SEC looks more closely at the links in the chain of the lucrative securities-lending world. Private lawsuits could help to lift the lid further, if they make it to trial. Last year, a host of Wall Street firms, including Goldman Sachs, UBS and Morgan Stanley, settled a naked-shorting case with shareholders of Taser International for an undisclosed sum.

A case brought by Overstock against Goldman and Merrill Lynch, for conspiring with clients to allow naked shorting of its shares, was dismissed in January on jurisdictional grounds. The online retailer, determined to see four years' worth of discovery and depositions receive an airing in court, is appealing. The banks have vigorously denied that they actively took part in an illegal scheme. But it seems clear that abusive shorting is not just the figment of a few executives' imaginations.